A payment bond is a type of surety bond. Contractors get these bonds because most construction projects require them, and they guarantee that laborers, subcontractors and suppliers of materials will be paid on time. This ensures not only that everyone is happy but also that the project will finish lien-free.
The payment bond is usually issued with the performance bond in the construction industry — although they are two different things. The payment bond is a contract between three parties: the contractor, the owner and the surety.
Payment bonds protect subcontractors, providing legal recourse against contractors who do not live up to their side of the bargain. If a contractor doesn't pay as agreed, laborers and suppliers can file a claim against the payment bond and receive compensation from the surety.
Payment bonds versus performance bonds: what’s the difference?
Payment bonds and performance bonds are sometimes confused, but they are not the same. A performance bond guarantees that all duties specified in the contract will be performed satisfactorily. If the customer can show that the work was not performed to specifications, surety will pay the claim, and then recovery from the contractor.
Payment bonds cover payment of workers and materials, and performance bonds ensure the work is done to specification pursuant to the contract's terms.
When and why do I need a payment bond?
Typically, contractors purchase the payment bond and the performance bond in the same package during the contract negotiation phase before a construction project starts. In order to secure a payment bond, contractors must be licensed and bonded — that is, they must possess a contractor license bond to legally work.
The federal Miller Act requires payment bonds on all federally-funded projects of $100,000 or more. Most state-funded projects have their own “Little Miller Acts” which require payment bonds. Many private project developers also require payment bonds.
Do subcontractors need a payment bond?
The general contractor is generally required to provide a performance bond for a public project. As part of that requirement, a payment bond is also included; in fact, it’s considered the same bond or policy. Sometimes the payment portion is not required, but generally it is.
In some cases, subcontractors also are required to have performance bonds, and often payment bonds as well. All of these requirements are dictated by the contract for each project.
General contractors (GC) are smart to require that their subcontractors be bonded. Obviously, if the subcontractor defaults on their work, the general contractor can claim against the subcontractor's bond. Furthermore, if the subcontractor does not pay their workers or suppliers, and they do not have a payment bond in place, the GC can also have financial exposure for the amounts owed.
Lesson learned: Bonds protect parties from default and are always better to have than not. Just like it is with insurance, you can gamble on everything going well and skip paying the premium, but when trouble or disaster strikes, it's much better to have the protection. Bonding means the contractors in question, whether they’re general contractors or subcontractors, have been vetted by the bonding companies for their experience and financial strength.
What’s the difference between payment bonds versus mechanic’s liens?
Another source of confusion surrounding payment bonds comes from mechanic's liens. The mechanic lien is a type of security interest placed on property that can help get a laborer paid for work. However, this kind of lien cannot be placed against public property. This is why the payment bond is typically needed for government-funded projects; it is the only option for many subcontractors and suppliers to ensure they get paid for their work.
The cost of payment bonds
How much payment bonds cost depends on the conditions of the contract the bond will cover. It is a percentage of the contract's amount, called a premium.
The surety company looks at several factors when they determine how much the premium should be, your personal credit score most of all. Those with strong credit scores will usually be offered a payment bond at 1% to 4% of the total amount. However, those with credit challenges can also receive a payment bond. For large contracts in excess of $250,000, financial records and other documentation, both business and personal, will likely be required also.
Why payment bonds are important to the construction industry
Private sector firms complete nearly all public construction work in the U.S. Contractors and firms receive jobs by being the lowest bidder to respond to the call in the competitive bid system. To make this system work, surety bonds are essential for several reasons — and payment bonds fit into this picture.
The government needs to use private contractors, and it's not always easy to choose which contractors to use. However, there are some easy things to agree on:
- government contracts should only go to those who are solvent
- who have the technical qualifications to perform the contract to specifications
- who will finish the contract on time
- who will finish the work at the agreed upon price
- who will comply with the plans; who will refrain from cheating
- who operate a safe job site and follow all safety procedures and laws
Payment bonds are part of the surety bond screening system. This system helps to weed out contractors who are less responsible, ethical and qualified. It also ensures that people will be paid, and projects will be finished, regardless of problems along the way.
Laborers, taxpayers, subcontractor, and material suppliers would be vulnerable without payment bonds. There are many reasons why there is not a better way to “weed out” undesirable contractors in advance of awarding contracts.
For example, because each project (and contractor) is unique, there is no way to create a set of objective standards that always work when screening bidders. Instead, if everyone is bonded, this issue is moot. Furthermore, without bonds, all conflicts end up in court — a costly, time-consuming process that makes all involved parties unhappy.
Moreover, if someone decides that a contractor is right for a job in error and there is a problem, without a bond, the cost of a delayed or incomplete job, and rushing to fix it later, is passed on to the taxpayers. Surety companies pay for their mistakes themselves. With the lowest bidder in a group of bidders who are all bonded, this is not an issue.
The bottom line
Payment bonds make it possible for the government to get big projects done, and for private contractors to work on large public construction projects. Everyone gets paid, and jobs get done. Perhaps most important, although often overlooked, the government and the taxpayers don't foot the bill for contractors who default on their promises.
Viking Bond Service, Inc. provided this content.